At the end of the year we are all typically anxious to see how our portfolios did. After all,
if our portfolio did better than the market, we can brag to our neighbors, friends and that
annoying brother-in-law about how smart we are! In actuality, all this means is that we
outperformed the index of the largest U.S. stocks. If we carry a diversified portfolio, is
this really a valid benchmark? Instead, we are better served, however, to see if we can
learn something from last year’s market returns and look at our portfolio results a little
bit differently. Following are some not-so-obvious lessons to learn about looking at
historical data.
As is often the case, investment returns for 2007 were mixed. It was a very volatile, up-
and-down market all year long. Just when we started to feel good, some news would
break and the market would take a dive.
The S&P 500 stock index, which represents large domestic stocks, was up a modest
5.49% for the year, according to Morningstar®, the mutual fund rating company. Small
stocks, as measured by the Russell 2000 index were down 1.57% for the year. Growth
stocks of all sizes performed much better. For example, Morningstar’s Large Growth
Index was up 12.34% for the year. Overall, bonds did well, as evidenced by the
Lehman Brothers (LB) U.S. Aggregate Bond Index, which was up 6.97%. Some bond
funds, however, were impacted negatively by the sub-prime mortgage fiasco and fared
much worse than the LB index.
International funds continued to do well. The Morgan Stanley (MSCI) Europe, Asia, Far-
East Index (EAFE) was up a sound 11.17% for the year. World bonds (includes U.S.
bonds) performed well, returning a solid 7.46% for the year. High yield bonds had a
very poor year, returning a paltry 1.47%. Real estate equities turned in a very bad
performance following several years of exceptional performance. Real estate equities
were down 14.63% for the year.
Unless you were lucky enough to have picked only the winning asset classes, you
probably aren’t in a position to go bragging about your returns. If you were well
diversified, you likely had some winners and some losers for an overall modest, positive
return.
So what can we learn from this data? First, it’s natural to look at the results and be
tempted to think that it’s possible to pick next year’s hottest asset classes and load up
on them. However, it’s very difficult to know what the winners will be from year to year.
Timing the market consistently is extremely difficult to do. Plus, you have to be right
twice. You have to know when to buy a particular asset and when to sell it. Being right
just once is very difficult to do. So, lesson number one is that we must own a broadly
diversified portfolio of the major asset classes. Doing so will lower portfolio risk and
increase returns over the long haul.
Many would look at these results and conclude that they should sell any real estate
equities in their portfolio, since real estate as an asset class was down 14.63% for the
year. Instead, they should consider buying real estate equities. Investors often confuse
a broad asset class in the down phase of its cycle with a poorly performing mutual fund.
Mutual funds that are not performing as well as their peers in the same asset class
should be given a wary eye and perhaps, discarded. The second lesson is: when one
of your asset classes has dropped significantly below your target portfolio allocation, it’s
time to buy more. You may not buy at the bottom of the cycle, but if you rebalance your
portfolio periodically, it has the same affect as dollar-cost averaging; it will lower your
overall average cost.
Finally, when we focus on last year’s market results, we often overlook two very key
factors of investment success: taxes and expenses. Advisor fees, mutual fund
transaction costs and expenses can substantially reduce portfolio performance.
Excessive trading not only increases fees but reduces tax efficiency. If portfolio fees are
high and fund distributions trigger substantial taxes, overall returns can be significantly
reduced. The final lesson is to not focus just on returns but also on the associated cost
and tax implications of your investment strategy.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, February, 2008,
Lessons to Learn from Last Year's Market Results
By David and Erin Patterson